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Business LibreTexts

6.6: Summary and Key Terms

  • Page ID
    10428
  • Section Summaries

    6.1 Calculate Predetermined Overhead and Total Cost under the Traditional Allocation Method

    • Manufacturing overhead is estimated for the upcoming period.
    • An activity base is selected to allocate overhead. This is traditionally direct labor hours, direct labor cost, or machine hours.
    • A predetermined overhead rate is calculated by dividing the estimated overhead by the allocation base.
    • Overhead is allocated to each product based on the estimated predetermined overhead rate and the number of units in the selected activity base.

    6.2 Describe and Identify Cost Drivers

    • Overhead costs are analyzed and grouped based on similar activity bases. A cost driver, such as inspections, machine setups, or order taking, is selected for each cost grouping.
    • Analysis of cost drivers allows for better selection of true overhead cost drivers and more appropriate allocation of overhead.

    6.3 Calculate Activity-Based Product Costs

    • Costs can be traced to the unit level or batch level.
    • There are five steps in the ABC process:
      • identify activities needed for production
      • assign overhead expenses
      • assign a cost driver for each expense
      • determine a predetermined overhead rate
      • allocate overhead to each product

    6.4 Compare and Contrast Traditional and Activity-Based Costing Systems

    • Traditional allocation assigns overhead based on a single overhead rate, while ABC assigns overhead based on several cost pools and the activities that drive costs.
    • Traditional allocation is optimal when the manufacturing process is labor driven and overhead increases based on traditional activity bases, such as direct labor hours, direct labor dollars, or machine hours.
    • ABC costing is optimal when the manufacturing process is technology driven and overhead increases based on various activities that differ for each product.

    6.5 Compare and Contrast Variable and Absorption Costing

    • Absorption costing assigns all manufacturing costs to products, whereas variable costing only assigns variable costs to the products.
    • Income statements from both methods can be reconciled by starting with the net income or loss using variable costing and adding the amount of fixed costs included in ending inventory and subtracting the fixed costs included in beginning inventory.
    • Variable costing is not considered GAAP compliant but lends itself to cost-volume-profit analysis.

    Key Terms

    absorption costing
    (also, full costing) system of accounting where all costs are treated as product costs regardless of whether they are variable or fixed
    activity base
    activity that has been considered to be a primary driver of overhead costs and for which, traditionally, direct labor hours or machine hours were used
    activity-based costing
    process of assigning overhead to products based on the cost driver for each activity cost pool
    batch-level cost
    one that is incurred when a group (or batch) of items is produced
    common fixed costs
    expenses that are shared among all divisions or production units and include such costs as the CEO salary and corporate headquarter costs
    cost driver
    activity that is the reason for the increase or decrease of another cost; examples include labor hours incurred, labor costs paid, amounts of materials used in production, units produced, or any other activity that has a cause-and-effect relationship with incurred costs
    cost pool
    accumulation of costs that are incurred during the production of the activities included in the activity cost pool
    direct labor
    labor directly related to the manufacturing of the product or the production of a service
    direct materials
    materials used in the manufacturing process that can be traced directly to the product
    expense recognition principle
    (also, matching principle) matches expenses with associated revenues in the period in which the revenues were generated
    factory-level cost
    one that is incurred when production occurs, such as production supervisor salary
    indirect labor
    labor not directly involved in the active conversion of materials into finished products or the provision of services
    indirect materials
    materials used in production but not efficiently traceable to a specific unit of production
    manufacturing overhead costs
    all manufacturing costs excluding direct material and direct labor
    product-level cost
    one that occurs as support of the product, such as engineering
    traditional allocation
    allocation of factory overhead to products based on the volume of production resources consumed
    unit-level cost
    one that is incurred for each unit produced
    variable costing
    (also, direct costing or marginal costing) system of accounting where only variable costs are treated as product costs